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Volatility Is Back: What To Do Now

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Volatility Is Back: What To Do Now

QS RESEARCH GROUP

FEBRUARY 07, 2018

These have been wild days for U.S. equity markets. Since Friday, the S&P 500 erased all its 2018 gains. Monday was the worst day for equities in more than six years. In two trading days, the S&P 500 lost 6.13%. Right after it opened on Tuesday, the New York Stock Exchange dipped into correction territory. Fortunately, it reversed course and quickly moved back up.

“Corrections” are defined as a 10% drop in markets to adjust for overvaluation. Markets can correct when investor optimism pushes prices too far ahead of underlying fundamentals, leading to profit taking. This can stoke broad panic selling that pushes prices even lower.

In review, cyclical sectors, such as information technology and financials, alongside energy, realized the steepest losses. Five stocks contributed roughly 20% of the S&P 500’s losses over Friday and Monday: Apple, Microsoft, Exxon, Berkshire Hathaway and Alphabet. Defensive sectors such as utilities and real estate drew down the least as investors sought refuge.

Still, the S&P 500 index remains at levels achieved on Dec. 8, 2017. The S&P 500 is trading at 22 times trailing earnings, near the highest since 2004, according to FactSet.

Our 2018 market outlook remains positive: We believe U.S. equities should deliver positive returns for the upcoming year. This should be driven by healthy U.S. and global economic growth; continuing U.S. earnings growth; and strong consumer spending, owing to low unemployment.

Investors should stay in U.S. equities but pursue a well-diversified strategic asset allocation that includes defensive equities to help smooth the ride. Defensive equities can help investors stave off market-timing decisions that are so detrimental to long-term returns. Over the last 35 years, the best predictors of defensive equity success are periods of low volatility (when they generated 4% outperformance) and strong economic growth (5% outperformance).

At the moment top sectors to invest in include industrials, utilities and consumer discretionary. Sectors to be careful of include technology, which has had a great run, so now may be a good time to rotate.

Some form of near-correction may have been inevitable, given how “frothy” markets became. Investors grew overly complacent, watching their equity holdings soar up and up with unusually low volatility (you have to look back to 1964-'65 to find a similar period). This underreaction may have turned to overreaction, which is typical human behavior. Market corrections are normal. Bloomberg data from the last 30 years shows they generally occur every 15-18 months[1], but it has been roughly two years since the last. That can make it feel particularly painful.

After months of lagging, volatility swiftly re-emerged. The CBOE Volatility Index (VIX) surged almost 260% since Friday, achieving its largest percentage rise ever on Monday, at 115.6%. The VIX closed Monday at 37.32, above its 10-year average for the first time since Nov. 4, 2016. Early Tuesday it briefly rose over 50, the highest level since August 2015.

According to Jefferies: Since 1990, once the VIX closed above 40, it took a median of 114 days to drop below 20; and once the VIX closed above 50, it took 306 days to fall below 20. It can be challenging to predict when market volatility will strike, even with positive fundamentals.

Investors suddenly appear to be concerned that we moved from a goldilocks environment (“not too hot, not too cold”) to an overbaked “too-hot” economy. If this does cause inflation to rise, the U.S. Federal Reserve could pursue more interest rate hikes in a shorter time frame. Getting monetary policy right is very hard and the Fed could slam the brakes on U.S. economic growth. The U.S. economy is already running at capacity constraints, thanks to full employment. The fiscal stimulus of corporate and individual tax cuts may have put us over the edge to unsustainable growth.

There are other risks. With such high valuations (the S&P 500 price-to-earnings ratio is at 22, the Schiller P/E at 32), investors' expectations of growth may be unrealistic. In addition to risk of overly aggressive interest rate increases, political risk is also worrisome. Our political divisions could give investors pause given necessary budget approvals and constant battles to extend the debt ceiling. Geopolitical risks bubble away, including potential U.S. trade policy changes – especially NAFTA.

Where will U.S. equity markets go from here? Let’s get through this week, then ask again.

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